Optimal portfolios and currency of choice
One question faced by global investment managers is how best to incorporate locally denominated security returns into a mean-variance portfolio analysis. As a concrete example, consider an investment management team who must invest in securities listed on the Tokyo Stock Exchange but whose principal client base is in US and hence interested only in USD returns. The team could conduct the analysis in local currency (JPY) terms, preparing the inputs to the M-V optimization, namely the means and covariances of security returns in JPY, and generate an efficient frontier in local currency the Yen. Alternatively, the team could prepare the same means and covariances in USD terms thereby taking into account the co-variability of local security returns and USD/YEN exchange rates. The question remains whether the efficient frontier will remain the same no matter how the analysis is conducted. A relevant question is whether the weights are independent of the currency of choice in optimization.
Real life examples are US-listed funds such as the Japan Equity Fund (JEQ) or The Japan Smaller Capitalization Fund (JOF) both closed-end funds listed in US but focused on the Japanese stock market. The principal investors in each fund are US entities according to recent 13F US regulatory filings. Other, more complicated example is the Goldman Sachs Dynamic Opportunities Fund (GSDO), a closed-end fund listed in Guernsey. The Fund’s objective is multi-strategy global and has three share classes (GBP, USD and EUR based). Whether GSDO manager should manage the portfolio as a single entity in one of the local currencies or in all three home currencies, taking into account the co-variability and security returns and exchange rates is a decision that the must be made by the fund managers.
From a theoretical perspective a US investor would be better if the investment team took into consideration currency movements and therefore would prefer a portfolio constructed with using exchange rate adjusted USD security returns. The same is true for UK and Europe based investors.
The present paper addresses this question using a sample of returns on 33 index groups on the Tokyo Stock Exchange. We find that portfolios toward the top of the efficient frontier are the same regardless of currency of denomination used in optimization. Thus exchange rate movements need not be taken into account by the investment team for higher risk portfolios. In contrast, we find that portfolios selected further down the efficient frontier, lower risk portfolios, currency movements do make a difference. These findings suggest that global fund managers are free to choose the currency of denomination in optimization as long as their clients have low degrees of risk aversion. However this result does not hold for portfolios managed for clients that have higher risk aversion.